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The Heckscher – Ohlin’s Theory of International Trade (with its Assumption)

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The Heckscher – Ohlin’s Theory of International Trade with its Assumption!

The classical comparative cost theory did not satisfactorily explain why comparative costs of producing various commodities differ as between different countries. The new theory propounded by Heckscher and Ohlin went deeper into the underlying forces which cause differences in compara­tive costs.

They explained that it is differences in factor endowments of different countries and different factor-proportions needed for producing different commodities that account for difference in comparative costs.

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This new theory is therefore-called Heckseher-Ohlin theory of international trade. Since there is wide agreement among modern economists about the explanation of international trade offered by Heckscher and Ohlin this theory is also called modern theory of international trade. Further, since this theory is based on general equilibrium analysis of price determination, this is also known as General Equilibrium Theory of International Trade.

It is worthwhile to note that, contrary to the viewpoint of classical economists, Ohlin asserts that there does not exist any basic difference between the domestic (inter-regional) trade and inter­national trade. Indeed, according to him, international trade is only a special case of inter-regional trade.

Thus, Ohlin asserts that it is not the cost of transport which distinguishes international trade from domestic trade, for transport cost is present in the domestic inter-regional trade. Trade because currencies of different countries are related to each other through foreign exchange rates which determine the value or purchasing power of different currencies.

Ohlin, therefore, regards different nations as mere regions separated from each other by national frontiers, different languages and customs, etc. But these differences are not such that prevent the occurrence of trade between na­tions. He, therefore, asserts that general theory of value which can be applied to explain inter­regional trade can also be applied equally well to explain international trade.

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According to general equilibrium theory of value, relative prices of commodious are deter­mined by demand for and supply of them. In the long-run equilibrium under conditions of perfect competition, relative prices of commodities, as determined by demand and supply, are equal to average cost of production.

The cost of production of a commodity, as is well-known, depends upon the prices paid for the factors of production employed in the production of that commodity. Factor prices in turn determine the incomes of the factor owners and hence the demand for goods.

Thus there is mutual inter-dependence between prices of commodities and prices of factors and the ex­change of goods and factors between different individuals in a region or country. This is how general equilibrium theory of value explains prices of commodities and factors between different individu­als in a region or a country.

However, according to Ohlin, the classical analysis presumes it to apply to a single market in a country and ignores the space factor whose introduction is crucial for expla­nation of trade between regions. The factors which explain the trade between different regions also explain the trade between different nations or countries as well.

Heckscher-Ohlin Theory:

According to Ricardo and other classical economists, international trade is based on differences in comparative costs. It is important to note that Heckscher and Ohlin agreed with this fundamental proposition and only elaborated this by explaining the factors which cause differences in compara­tive costs of commodities between different regions or countries. Ricardo and others who followed him explained differences in comparative costs as arising from differences in skill and efficiency of labour alone.

This is not a satisfactory explanation of differences in comparative cots. Ohlin pointed out more significant factors, namely, differences in factor endowments of the nations and difference in factor proportions of producing different commodities, which account for differences in com­parative costs and hence from the ultimate basis of inter-regional or international trade.

Thus, Heckscher-Ohlin theory does not contradict and supplant the comparative cost theory but supple­ments it by offering sufficiently satisfactory explanation of what causes differences in comparative costs.

According to Ohlin, the underlying forces behind differences in comparative costs are two- fold:

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1. The different regions or countries have different factor endowments.

2. The different goods require different factor-proportions for their production.

It is a well-known fact that various countries (regions) are differently endowed with productive factors required for production of goods. Some countries posses relatively more capital, some rela­tively more labour, and some relatively more land.

The factor which is relatively abundant in a country will tend to have a lower price and the factor which is relatively scarce will tend to have a higher price. Thus, according to Ohlin, factor endowments and factor prices are intimately associ­ated with each other, Suppose K stands for the availability or supply of capital in a country, PL for that of labour and PK for price of capital and PL for the price of labour.

Further, take two countries A and 5; in country A capital is relatively abundant and labour is relatively scarce. The reverse is the case in country B. Given these factor-endowments, in country capital will be relatively cheaper.

In symbolic terms:

Thus the differences in factor endowments cause differences in factor prices and therefore ac­count for differences in comparative costs of producing different commodities.

Together with the difference in factor-endowments, differences in factor proportions required for the production of different commodities also constitute an important force underlying differ­ences in comparative costs as between different countries. Some commodities are such that their production requires relatively more capital than other factors; they are therefore called capital- intensive commodities.

Still other commodities require relatively more land than capital and labour and are therefore called land-intensive commodities. These differences in factor-productions (or what is also called differences in factor-intensities) needed for the production of different commodi­ties account for differences in comparative costs of producing different commodities. The differ­ences in comparative costs of producing different commodities lead to the differences in market prices of different commodities in different countries.

It follows from above that some countries have a comparative advantage in the production of a commodity for which the required factors are found in abundance and comparative disadvantage in the production of a commodity for which the required factors are not available in sufficient quanti­ties.

Thus a country A which has a relative abundance of capital and relative scarcity of labour will have a comparative advantage in specialising in the production of capital-intensive commodities and in return will import labour-intensive goods. This is because (PK/PL)A < (PK/PL)B.

On the other hand, a labour-abundant country B with a scarcity of capital will have a compara­tive advantage in specialising in the production of labour-intensive commodities and export some quantities of them and in exchange for import capital-intensive commodities. This is because in this country (PL/PK)B < (PL/PK)A .

If factor endowments in the two countries are the same and factor-productions used in the production of different commodities do not different there will be no differences in relative factor prices [ i.e., (PK/PL)A < (PK/PL)B] which will mean differences in comparative costs of producing commodities in the two countries will be non-existent. In this situation the countries will not gain from entering into trade with each other.

Let us graphically explain the Heckscher-Ohlin theory of international trade. Take two coun­tries U.S.A. and India. Assume that there is a relative abundance of capital and scarcity of labour in U.S.A. and, on the contrary, there is a relative abundance of labour and scarcity of capital in India. (This is the real situation as well).

Given these factor endowments we have drawn the production possibility curves (also known as transformation curves) between two commodities, cloth and ma­chines of the two countries, U.S.A. and India in Fig. 44.1 and 44.2 respectively.

Since the two countries have different factor endowments their production possibility curves will differ. As will be seen from Fig. 44.1, the production possibility curve AB of U.S.A. shows that given its factor en­dowments, U.S.A. can produce relatively more of capital-intensive commodity machines and rela­tively less of labour-intensive commodity cloth. On the contrary, as will be seen from Fig. 44.2 with given factor endowments, India can produce relatively more of labour-intensive commodity cloth and relatively less of capital-intensive commodity machines.

In the absence of foreign trade, equi­librium in each country would be determined by the following rule:

MRTMC=MRSMC = PM/PC

Where MRS stands for a marginal rate of transformation of machines into cloth, MRSMC for marginal rate of substitution of machines for cloth and PM/PC for the price ratio between the machines and cloth.

In the geometric terms, the above rule implies that in the absence of foreign trade the produc­tion and consumption in the two countries would take place at the tangency point of the given production possibility curve with the highest possible community indifference curve.

It will be observed from Figure 44.1 that in the absence of trade, U.S.A. will be in equilibrium position with production and consumption at point R where its production possibility curve AB is tangent to its community indifference curve II. The tangent pp to the production possibility curve AB and the community indifference curve II at point R indicate the ratio of price of the two com­modities (i.e. the domestic rate of exchange) before trade in U.S.A.

As regards India, as shown in Figure 44.2 before trade, she will be in equilibrium with produc­tion and consumption at point Q at which its production possibility curve is tangent to its community indifference curve II. Tangent pp at point Q to its production possibility curve EF and the commu­nity indifference curve II shows the domestic rate of exchange of two commodities before foreign trade.

It will be seen from Figures 44.1 and 44.2 that the price ratio (rate of exchange) of the two commodities in the two countries differs (slopes of tangents pp in them vary). It will therefore pay the two countries to enter into trade with each other.

Suppose, the terms of trade, that is, the ratio of exchange of goods between the two countries is given by the line tt. It will be observed that with terms of trade line tt, U.S.A. will be in equilibrium from the view point of production at point R’ at which the terms of trade line tt is tangent to its production possibility curve AB.

However, its con­sumption point after trade is C which is determined by the tangency of the terms of trade line tt with the community indifference curve III. It will be seen from Figure 44.1 that in U.S.A. the consump­tion point C after trade lies at a higher indifference curve than before trade indicating the gain from trade it obtains.

The consumption point C of U.S.A. as compared to its production point R’ after trade reveals that U.S.A. produces HR’ more of machines and HC less of cloth than it consumes domestically. Thus U.S.A. will export HR’ of machines and import HC of cloth.

As regards India, it is evident from Figure 44.2 that as a result of trade its production point will shift to point Q’ where its product possibility curve EF is tangent to the terms of trade line tt. After trade, consumption in India will take place at point C at which the terms of trade line tt is tangent to its community indifference curve III.

As a result of trade India has also gained as she has reached a higher community indifference curve. Thus after trade with the production point Q’ and consump­tion point C, India will produce SQ’ more of cloth and SC less of machines than it consumes at home. Thus India will export SQ’ of cloth and import SC of machines.

It follows from above that due to differences in factor endowments in U.S.A. and India and also due to different factor proportions required for the production of different commodities the basis for trade between the two countries exists and both would gain from trade by specialising in the produc­tion of commodities which require factors in respect of which they are well endowed and will import those commodities which need factors which are relatively in scarce supply.

Equalisation of Factor Prices:

As explained above, trade takes place when relative prices of commodities differ between coun­tries due to difference in comparative costs. The volume of trade goes on expanding until the differ­ences in relative prices of commodities (ignoring transport costs) are eliminated.

Thus, in the ab­sence of transport costs and tariffs, the effect of trade would be to equalise the relative commodity prices in the trading countries. For instance, in the example given above, as a result of trading between U.S.A. and India under the given conditions, the exports of machines to India by the U.S. A will lower the prices of machines in India and raise them in U.S.A.

This is because before opening up of trade, the price of machines was relatively high in India as compared to that in U.S.A. Now, with the increase in supply of machines in India due to their imports from U.S.A., their prices will fall.

On the other hand, prices of machines in U.S.A. will rise due to the reduced supply in the domestic market than before as a result of their exports to India. Thus the prices of machines would tend to rise in U.S.A. and those in India would tend to fall.

The flow of trade would continue expanding until the prices of machines in the two countries (in the absence of transport costs and tariffs) would become equal. Likewise, the price of cloth which before trade is lower in India than in U.S.A. would tend to become equal in the two countries following the opening up of trade between them.

Equalisation of factor prices:

It is important to note that trade tends to equalise not only commodity prices but also factor prices. The exports of a product using the abundant factor by a country will cause the demand for that factor to increase and thereby make it relatively less abundant and raise its price. On the other hand, the imports of a product embodying large amounts of relatively scarce factor would make it less scarce and tend to lower its price. Thus changes in factor prices following the trade of com­modities between the two countries result in equalisation of factor prices in them.

Let us take an example. As noted above, in U.S.A. capital is relatively abundant and cheap whereas labour is relatively scarce and expensive. On the contrary, in India labour is relatively abundant and cheap whereas capital is scarce and expensive.

With these factor endowments it will pay India to export labour-intensive commodity cloth which can produce it at a cheaper price and in exchange to import capital-intensive commodity machines from U.S.A. which can produce them at a lower price.

As a result of this trade, the demand for labour in India would increase and its price would tend to increase. Now, with the imports of labour-intensive commodity cloth by U.S.A. and concentrating its more resources on production of capital-intensive machines, the demand for labour in U.S.A. would decrease and its price would tend to fall.

Thus, other things remaining the same, the price of labour in India and U.S.A. would tend to become equal after opening up of trade between the two countries. The same applies to the price of capital. To sum up, according to Heckscher- Ohlin theory, free trading of commodities between the two countries results in equalisation of fac­tor prices. If factors were mobile between countries, then the free movement of factors from one country to another would have equalised their prices.

But in actual practice factors lack interregional and international mobility. Therefore, in ab­sence of trade of commodities, factor prices would not tend to the become equal in the different countries. Thus Ohlin argues that what would have been accomplished through free movement of factors between countries is indirectly accomplished through movement of commodities embodying different factor-proportions. Indeed, according to Ohlin, international trade in commodities serves as a substitute for international mobility of factors.

It is worthwhile to note that trade would achieve complete factor price equalisation only when some conditions and assumptions are fulfilled. It is also realised that these conditions and assump­tions are quite restrictive so that in actual practice differences in factor-prices are not completely eliminated.

The conditions and assumptions underlying the factor-price equalisation theorem are:

1. Tastes, that is, demand pattern for commodities, are the same.

2. It is the supply conditions of the factors which are different in different countries and no qualitative differences prevail in them. This implies that the level of technological progress is the same in the different countries.

3. Production function of each commodity is the same in the different countries and is of a simple character, that is, it is either capital-intensive, or labour-intensive. In other words, production functions of commodities provide a limited degree of factor substitution.

4. There are no restrictions on trade in the form of tariffs and quotas in the trading countries.

5. There are no transport costs.

6. There exists perfect competition in the commodity market as well as in factor markets in each region or country.

Since in the real world, above conditions are not fulfilled, complete factor price equalisation does not take place. However, this does not invalidate the factor price equalisation theorem. Indeed, every theory is based upon some assumptions. What this theory asserts is that, given the above conditions, factor prices would become equal. To the extent these conditions do not exist, factor prices will remain unequal even after trade takes place between the countries.

Critical Evaluation of Heckscher-Ohlin Theory of International Trade:

Heckscher and Ohlin theory has made invaluable contributions to the explanation of interna­tional trade. Though this theory accepts comparative costs as the basis of international trade, it makes several improvements in the classical comparative cost theory.

First, it rescued the theory of international trade from the grip of labour theory of value and based it on the general equilibrium theory of value according to which both demand and supply conditions determine the prices of goods and factors.

Second, Heckscher-Ohlin theory removes the difference between international trade and inter-regional trade, for the factors determining the two are the same.

Third, a significant improvement is the explanation offered for difference in comparative costs of commodities between trading countries. Ricardo thought that the differences in labour efficiency alone accounted for the differences in comparative costs.

According to Heckscher and Ohlin, as seen above, the differences in factor-endowments of the countries and also the differences in factor proportions required for producing various commodities explain differences in comparative costs and hence from the ulti­mate basis of international trade. These reasons advanced by Heckscher and Ohlin for differences in comparative costs of commodities in different countries are considered to be broadly true.

Fourth, as has been pointed out by Prof. Lancaster, Heckscher-Ohlin model provides a satis­factory picture of the future of foreign trade. According to the Ricardian theory, international trade exists because of differences in skill and efficiency of labour alone.

This implies that as there is transmission of knowledge between the countries so that they master the techniques and skills of each other, then differences in comparative costs would cease to exist and as a result international trade would come to an end. But this is not likely to occur despite the fact that transmission of knowledge and techniques has greatly increased these days.

Heckscher and Ohlin explain that inter­national trade is due to the differences in factor-endowments (i.e. differences in supplies of all factors and not only of labour efficiency) and different factor-proportions required for different commodities.

Since the factors such as land and other natural resources lack mobility, international trade would not cease to exist even if there is perfect transmission of knowledge between the coun­tries.

Despite the above merits of Heckscher-Ohlin theory, it has some shortcomings which are briefly discussed below:

1. In the Heckscher-Ohlin theory:

It has been assumed that relative factor prices reflect the relative supplies of factors. That is, a factor which is found in abundance in a country will have a lower price and vice versa. This means that in the determination of factor-prices supply outweighs demand.

But if demand for factors prevails over supply, then factor prices so determined would not conform to the supplies of factors. Thus, if in a country there is abundance of capital and scarcity of labour in physical terms but there is relatively much greater demand for capital, then the price of capital would be relatively higher to that of labour.

Then, under these circumstances, contrary to its factor-endowments, the country many export labour-intensive goods and import capital-intensive goods. Perhaps it is this which lies behind the empirical findings by Leontief that though America is a capital abundant and labour-scarce country, in the structure of its imports capital-intensive goods are relatively greater whereas in the structure of its exports labour-intensive goods are relatively greater. As this is contrary to the popularly held view, this is known as Leontief Paradox.

2. Differences in preferences or demands for goods:

Against Hecksher-Ohlin theorem, it has also been pointed out that differences in tastes and preferences for goods or, to put it in other words, differences in pattern of demand also give rise to trade between the countries. This is because under differences in demand or preferences for goods, the commodity price-ratios would not conform to the cost-ratios based on factor endowments.

Let us take an extreme example. Suppose there are two countries A and B with same factor-endowments. According to Heckscher-Ohlin theorem, with same factor endowments cost-ratio of producing the two commodities and hence the commodity price ratio would be the same.

Hence there is no possibility of trade between the two countries on the basis of Heckscher-Ohlin theorem. However, trade between the two countries is possible if the demand pattern or preferences of the people of the two countries for wheat and rice greatly differ.

This is illustrated in Fig. 44.3. Suppose people of country A prefer rice to wheat and people of country B prefer wheat consumption. With these preferences for wheat and rice we have drawn the community indifference curves of the two countries A and B. Since factor-endowments in the two countries are the same, PP is the production possibility curve in both of them.

In the absence of trade country A is in equilibrium at point D where its community indifference curve IIa is tangent to the production possibility curve PP. kk is the commodity price-ratio line determined in country A.

Country B is in equilibrium at point E where its community indifference curve IIb is tangent to the production possi­bility curve PP. JJ is the commodity price-ratio determined in country B. Thus, due to difference in demand (preferences) for rice and wheat in the two countries different commodity price ratios have come to prevail in the two countries though their factor endowments (and therefore the cost-ratios or the two commodities) are the same.

Because of the differences in commodity price ratios the trade is possible and will be mutually beneficial. The opening of trade would equalise commodity prices in the two countries and would therefore change their pattern of production giving rise to exports and imports by the two countries.

Let tt be the commodity price ratio (i.e. terms of trade) that is settled between the two countries. It will be noticed in Fig. 44.3 that with terms of trade tt each country would produce at point Q. But the consumption of the two commodities would be different in the countries.

After trade whereas country A’s consumption would be at R where terms of trade line tt is tangent to its indifference curve IIIa; country B’s consumption would be at point S on its indifference curve IIIb. It is evident that country/I would be importing GR rice and exporting GQ wheat, whereas country B would be exporting QH rice and importing HS wheat. It will be further noticed that through trade both have reached at their higher indifference curves indicating higher level of welfare than before trade.

Gains from Trade:

Foreign trade confers a good deal of benefits on the trading countries. If different countries specialise on the basis of their comparative costs, it would enable them to make optimum use of their resources and thereby add to their output, income and welfare of their people.

Gains from trade are broadly divided into two types:

(i) Static Gains

(ii) Dynamic Gains.

Static gains from trade refer to the increase in utility or welfare of the people of the trading countries as a result of the optimum utilisation of their given factor-endowments, for they specialise on the basis of their comparative costs. On the other hand, dynamic gains refer to the contributions which foreign trade makes to the overall economic growth of the trading countries. We shall explain below in detail these two types of gains.

Static Gains from Trade:

As stated above, static gains from trade are measured by the increase in the utility or level of welfare when there is opening of trade between the countries. Note that in modern economics increase in utility or welfare is measured through indifference curves. When as a result of foreign trade, a country moves from a lower indifference curve to a higher one, it implies that the welfare of the people has increased. To show the static gains from trade, let us take an example.

Suppose two commodities cloth and wheat are produced in two countries, India and U.S.A., before they enter into trade. Their production possibility and indifference curves are shown in Figures 44.4 and 44.5. It will be seen from Fig. 44.4 that before trade India would be in equilibrium at point F (i.e. producing and consuming at point F) where the price line pp’ is tangent to both production possibility curve AB and indifference curve IC1.

The slope of the price line pp’ shows the price-ratio (or cost ratio) of the two commodities in India. India can gain if international price-ratio (terms of trade) is different from the domestic price-ratio represented by pp’. Suppose the terms of trade settled are such that we get tt as the terms of trade line showing the price ratio at which goods can be exchanged between India and the U.S.A.

Now, with tt’ as the given terms of trade line (i.e. new price-ratio line). India would produce at point R at which the terms of trade line tt is tangent to her production possibility curve. It will be seen from Fig. 44.4 that at point R, India will produce more of cloth in which it has comparative advantage and less of wheat than at F.

Though India will produce at point R on his production possibility curve, where the terms of trade line tt are tangent to her production possibility curve AB it will not consume the quantities of wheat and cloth represented by the point R.

Given the new price-ratio represented by the terms of trade line tt the consumption of the goods will depend upon the pattern of demand of the country. To incorporate this factor we have drawn social indiffer­ence curves IC1 IC2 of the country. These social indifference curves represent the demands for the two goods, or, in other words, the scale of preferences between the two goods of the society.

It will be seen from Fig. 44.4 that the terms of trade line tt is tangent to the social indifference curve IC2 of India at point S. Therefore, after trade India will consume the quantities of cloth and wheat as represented by point S.

It is therefore clear that as a result of specialisation and trade India has been able to shift from point F on indifference curve IC1 to the point S on the higher indifference curve IC2. This is the gain obtained from specialisation and trade and implies that trade enables a country to increase her consumption beyond her production possibility curve. (It will be seen that point S lies beyond the production possibility curve AB of India).

It is also worth noting that when specialisation and trade occur, the quantities of the two goods consumed by a country will differ from the quantities of the two goods produced by her. In Fig. 44.4 whereas India produces the quantities of two goods represented by point R, it will consume the quantities of the two goods represented by the point S. The difference arises due to exports and imports of goods. In Fig. 44.4, while India will export MR quantity of cloth, it will import MS quantity of wheat.

Now consider the position of U.S.A. which is depicted in Fig. 44.5. Given its factor endow­ments CD is the production possibility curve between wheat and cloth of the U.S.A. It is evident from the production possibility curve CD that the factor endowments of the USA are more favourable for the production of wheat.

It will also be seen from Fig. 44.5 that before trade the U.S.A. will produce and consume at point E on her production possibility curve CD where the domestic price ratio line pp and indifference curve IC1 are tangent to it. The USA will gain from trade if it can sell at a different price ratio from pp. Suppose the terms of trade line is tt.

With this terms of trade line tt the U.S.A. will produce at point G on her production possibility curve CD. She will now produce more of wheat ill which she has comparative advantage and less of cloth than before. On the other hand, given the price ratio as represented by the terms of trade line tt the USA will consume the quantities of the two goods given by the point H where the terms of trade line tangent to her indifference curve IC2 is. It is therefore clear that the specialisation and consequently trade with India has enabled the U.S.A. to shift from her lower indifference curve IC2 to her higher indifference curve IC2. This is the gain which she obtains from trade.

By comparing the production and consumption points of the U.S.A. it will be observed that the U.S.A. will export NG amount of wheat and import NH amount of cloth.

It is worth remembering that while in case of constant opportunity cost, each country attains complete specialisation, that is, it produces one of the two goods after trade, in case of increasing opportunity cost specialisation is not complete. In case of increasing opportunity cost, a country produces only a relatively large amount of the good in which it has comparative advantage.

Dynamic Gains from Trade: International Trade and Economic Growth:

We have seen above in the discussion of comparative cost theory that specialisation followed by international trade makes it possible for the countries to have more of both commodities than before. This additional production of commodities is the gain which flows from specialisation by different countries in the production of different goods and then trading with each other.

Specialisation by different countries in the production of different goods according to their efficiency and resource endowment brings about an increase in the total world production by increasing the level of their productivity. It is this trade that makes possible the division and specialisation of labour on which higher productivity of different countries is so largely based.

If the various countries could not exchange the products of their specialised labour, each of them would have to be self-sufficient (i.e., each of them would have to produce all goods it requires, even those which it could not produce efficiently) with the result that their productivity and standard of living will go down.

Thus, accord­ing to Professor Haberler, “International division of labour and international trade, which enable every country to specialise and to export those things which it can produce cheaper in exchange for what others can provide at a lower cost, have been and still are one of the basic factors promoting economic well being and increasing national income of every participating country.”

We thus see that the main gain from specialisation and trade is the increase in national produc­tion, income and consumption of the participating countries. But the above explanation of gains from trade in terms of comparative cost theory deals only with static gains from trade, that is, the gains which accrue to a country from reallocation of a given amount of resources. We shall now discuss dynamic gains from trade that is gains from trade which accrue to a country in terms of promotion of its economic growth.

Dennis Robertson described foreign trade as “an engine of growth.” With greater income and production made possible by specialisation and trade, greater savings and investment become pos­sible and as a result higher rate of economic growth can be achieved.

Through promotion of exports, a developing country can earn valuable foreign exchange which it can use for the imports of capital equipment and raw materials which are so essential for economic development. Therefore, Profes­sor Haberler argues that since international trade raises the level of income, it also promotes eco­nomic development. He thus remarks: “What is good for the national income and the standard of living is, at least potentially, also good for economic development; for the greater the volume of outputs the greater can be the rate of growth—provided the people individually or collectively have the urge to save and to invest and economically to develop. The higher the level of output, the easier it is to escape the “vicious circle of poverty” and to “take off into self-sustained growth” to use the jargon of modern development theory. Hence, if trade raises the level of income, it also promotes economic development.

As pointed out above, the importance of and gain from international trade follows from the theory of comparative cost. Specialisation by different countries according to their production effi­ciency and factor endowments ensures optimum use and allocation of resources of the countries.

Differences in production possibilities and costs of production of various products between different countries of the world are so great that tremendous gain in terms of additional output and income accrues to the world community from international specialisation and trade.

For instance, the rela­tive differences in cost of production of industrial products and food and raw materials between developed and developing countries are almost infinite in the sense that either type of these coun­tries cannot produce what they buy from the other.

But the theory of comparative cost is static, it indicates only those gains which accrue to the trading countries as a result of the differences in given cost of production and given production possibilities of various products at a given point of time.

As pointed out above, besides the static gains indicated by comparative cost theory, international trade bestows very important indirect gains and benefits, which are generally described as dynamic gains, upon the participating countries. These dynamic gains also promote economic growth in the participating countries.

It is worth noting that both developed and developing countries have obtained benefits from trade. The international trade has contributed a good deal to the economic development of countries. To quote Professor Haberler again “If we were to estimate the contribution of international trade to economic development especially of the under-developed countries solely by the static gains from trade in any given year on the usual assumption of given production capabilities, we would indeed grossly under-rate the im­portance of trade. For over and above the direct static gains dwelt upon by the traditional theory of comparative cost, trade bestows very important indirect benefits upon the participating countries”.

Dynamic gains which’ accrue to the developing countries from international trade are as follows:

Firstly, through foreign trade, developing countries get material means of production such as capital equipment, machinery and raw materials which are so essential for economic growth of these countries. There has been rapid technological progress in the developed countries.

This advanced and superior technology is incorporated or embodied in various types of capital goods. It is thus clear that developing countries derive tremendous gains from technological progress in the devel­oped countries through the imports of capital goods such as machinery, transport equipment, ve­hicles, power generation equipment, road building machinery, medicines, and chemicals.

It is worth mentioning here that the pattern of import trade of the developing countries has changed in the last several years and now consists of greater quantity of various forms of capital goods and less of textiles.

Secondly, even more important than the importation of capital goods is the transmission of technical know-how, skills, managerial talents, entrepreneurship through foreign trade. When the developing countries come to have trade relationship with the developed countries, they also often import technical know-how, with all their skills, managers, etc., from them.

With this they are also able to develop their own technical know-how, managerial and entrepreneurial ability. The growth of technical know-how, skill and managerial ability is an important requisite for economic develop­ment of developing countries. Professor Haberler rightly says: “The late-comers and successors in the process of development and industrialization have always had the great advantage that they could learn from the experiences, from the successes as well as from the failures and mistakes of the pioneers and forerunners… Today the developing countries ‘have a tremendous, constantly growing store of technical know-how to draw from. True, simple adoption of methods, developed for the conditions of the developed countries is often not possible. But adaptation is surely much easier than the first creation….Trade is the most important vehicle for the transmission of technological know-how….Today there are a dozen industrial centres in Europe, the U.S., Canada, and Japan, and Russia which are ready to sell machinery as well as engineering advice and know-how.”